Can Textron Keep Its Secrets?

This summer, Textron's tug-of-war with the IRS over tax accrual work papers will head to the U.S. Court of Appeals. The decision could determine what company's are allowed to keep private.Marie Leone, CFO.com | USApril 23, 2008

The U.S. Court of Appeals is expected to rule this summer on a case that could determine whether companies have a right to keep secret their tax accrual work papers. The appeal, being brought by the Internal Revenue Service, involves conglomerate Textron Inc., and the company's effort to keep proprietary work papers private.

The appeals court decision could have wide-ranging consequences. Many companies produce tax accrual work papers, which contain legal opinions about tax positions, to inform their accounting decisions and support those decisions during independent audits. Exposing the work papers to public scrutiny, however, could give potential legal adversaries insight into the company's tax strategies, and a leg up on litigation. The work papers could also act like a bread crumb trail for the IRS, pointing the agency to aggressive tax strategies.

Last August, the U.S. District Court in Rhode Island ruled in favor of Textron, finding that the documents — related to nine "sales-in, lease-out" (SILO) transactions — were protected by the work product privilege doctrine. That principle protects the confidentiality of documents that are prepared in anticipation of litigation. Although the work papers are not part of a current law suit, they contain legal opinions about Textron's tax positions and the likelihood that the transactions would be challenged by the IRS and survive a tax audit.

And while Textron won its case under the work products doctrine, it lost its argument that the tax documents fell under the protection of attorney-client privilege. The attorney-client privilege protects confidential communication between the two parties related to legal advice sought from the attorney. Indeed, the court knocked down that Textron argument on the grounds that the company waived that protection when it shared the documents with a third party — its independent auditor.

In the ruling, Judge Ernest Torres wrote that "it is well established that 'voluntary disclosure to a third party waives the attorney-client privilege even if the third party agrees not to disclose the communications to anyone else.'" That principle, asserted Torres, has been applied specifically to disclosures made to independent auditors in cases involving First Federal Savings Bank of Hegewisch, Dupont, and Pfizer, and has been cited in specific tax-related cases involving BDO Seidman and KPMG.

Others have weighed in on the pivotal Textron case, including Financial Executives International, the trade group that counts among its ranks professionals who prepare both financial statements and tax returns. In an amicus brief filed this month in anticipation of the appeal, FEI asserted that the government's position "threatens the ability of companies to develop and protect assessment of their litigation positions, in tax and other areas, that are necessary for the proper operations of their businesses."

Among other claims, FEI argued that generally accepted accounting principles — specifically FAS 5, Accounting for Contingencies, requires companies to share tax work papers with auditors. Under FAS 5 companies must account for and disclose "material loss contingencies, which including potential litigation." Further, when evaluating whether accrual or disclosure is required under FAS 5 a company also should consider, among other things, "the opinions or views of legal counsel and other advisers." Indeed, an independent auditor will want to review the tax work papers, including the company's estimated tax reserves, before giving the client a "clean" audit.

But the idea of handing over tax accrual work papers to anyone other than attorneys and auditors has been a sore point for companies. In many cases, corporations keep legal opinions and other calculations related to taxes and tax reserves under wraps, for fear of tipping off the IRS or competitors. Exposing a possible weakness in a tax position or tax shelter could put the company at a disadvantage in a court case, as the opposing side would be able to prove that the company had doubts about the tax strategy.

In fact, the issue bubbled up in 2006 when the Financial Accounting Standards Board passed an accounting rule known as FIN 48,Accounting for Uncertainty in Income Taxes. The rule requires companies to disclose how much they have kept in reserve to cover the possibility that the IRS or state tax officials might disallow certain tax treatments, such as a company's claim for credits and deductions, exclusions of certain revenue from taxable income, or, say, the decision that a merger or other transaction can be considered tax-free.

But so far, corporations have not been forced to turn over tax accrual work papers to the government, although last year, the Senate's Permanent Subcommittee on Investigations was urging companies to release details related to tax transactions that account for 5 percent or more of their total tax reserve, as well as transactions in which the company paid tax advisors at least $1 million for their services.

In the case of Textron, the tug-of-war over work papers came to a head when the company refused to comply with an IRS summons issued in June of 2005, to produce the SILO documents that pertained to a 2001 tax return. Textron claimed that the summons was issued under the pretext that the government needed to review documents linked to the return. According to Textron attorneys, however, the IRS's "real objective" was to use the legal opinions about the SILO transactions as a bargaining chip to force the company into a settlement.

But the court didn't see it that way. While it is "improper" to issue a summons for documents "to harass the taxpayer or to put pressure on him to settle a collateral dispute," Torrres ruled that the IRS summons was proper. The opinion was a blow to Textron's defense, but not enough to change the court's final decision to pull the plug on the IRS summons.

The Textron work papers comprise three main elements: a spreadsheet identifying items on Textron's tax returns — that according to Textron attorneys, "involved issues on which the tax laws are unclear, and therefore, may be challenged by the IRS; estimates — expressed in percentage terms — made by Textron's legal team regarding the company's chances of winning a lawsuit against the IRS or other adversaries; and the tax reserve amounts related to the SILO transactions.

In February of 2005, the Treasury Department issued guidance that designated SILO arrangements as "abuse tax avoidance transactions." The government explained that a SILO transaction shifts tax benefits garnered by a lease transaction to an "indifferent" party that can't use the tax break to a party that can use it. But the IRS asserted that taxpayers that claim SILO-related benefits are not entitled to the break because they do not own the lease property that is entitled to the favorable tax treatment. As a result, the Treasury Department put companies on notice, warning corporations that the IRS would challenge the "purported tax benefits" of earlier SILO transactions.

On June 2, 2005, the IRS issued a summons for "all" of Textron's tax accrual work papers for the tax year ending December 29, 2001. When Textron refused to turn over the documents, the action promtped the IRS suit that is now headed to a summer showdown in the U.S. Court of Appeals.